Amity Business School

Amity Business School

MBA Class of 2014 , Semester II FINANCIAL MANAGEMENT MODULE III

Capital Structure
1

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Introduction Financing decision is raising the necessary funds to meet our investment expenditures. Most of the investment is done through borrowed funds. So, while making an investment decision it is necessary to see whether adequate funds are available or not. Because without a financing decision investment decision is not possible and without investment decision financing decision has no purpose

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In financing decision company has to decide its capital structure. In this the debt & equity ratio is decided. It also termed as debt equity mix. The capital structure or financing decision indicates the left side (Liabilities) of the balance sheet whereas investment decision shows right side (Assets) of the balance sheet. The capital structure shows the proportionate relationship between debt & equity.

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That is how these two decisions are correlated. In financing decision, we not only have to look at availability of funds but also at its cost. We have to pay in future, that is why the cost of capital is very significant decision. It (cost of capital) has two dimensional impacts like it affects both the investment and financing decision
Capital structure does not effect the earnings of the firm but it can effect the share of Earning available for the equity share holders

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Illustration1. ABC company has currently an all equity capital structure consisting Of 15000 equity shares of Rs.100 each. The management is planning To raise another 25 lakhs to finance a major Programme of expansion And is considering three alternative method of financing: i. To issue 25000 equity shares of Rs.100 each. ii. To issue 25000, 8% debenture of Rs.100 each iii. To issue 25000, 8% preference share of Rs.100 each. The companys expected earnings before interest and taxes will be Rs.8 Lakhs. Corporate tax rate is 50%. Analysis the options and suggest the Best alternative with reasons.

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Optimum Capital Structure A capital structure decision can influence the value of the firm through the cost of capital and trading on equity. The optimum capital structure may be define as that capital structure or combination of debt and equity that leads to the maximum value of the firm.

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Simplicity Flexibility Minimum Cost of Capital Adequate Liquidity Minimum Risk Legal Requirements Control Floatation Cost